The Ugly Truth About Selling Cheap Options

Selling cheap options with very high probabilities of success makes rationale sense on the outside. I mean, why sell options with a 70% chance of success when you can sell options further out that have a 90% chance of success. No brainer right? Well, not so fast. The options market is fair and efficient – and selling these far out-of-the-money options might look good from a win rate perspective, the total dollar profits you’ll generate far under-perform the stock market. Today, we’ll use our Options Backtesting software to run two option selling strategies on TLT. The first selling options at the 0.25 delta and the second selling options at the 0.05 delta. Inside we present the results and our analysis as to why selling cheap options could be less beneficial to your portfolio.

Key Points from Today’s Show:

In episode #102 we looked at different options prices and dug down into particular contract months for S&P call options.

Tested the 40, 30, 20 and 10 Delta options.

Looked at the differential between pricing and how far out they were from the money, probabilities of expiring in the money, etc.

This topic goes hand-in-hand with today’s episode.

In today’s show we look at a back-tested case study of a TLT strangle.

The strategy works across different ticker symbols and highly liquid ETFs.

The concepts and framework generally work across everything that we are trading.

We can use TLT to help prove this specific concept.

Often times when traders discover that they can sell options and generate a high probability of success, the natural default is to sell the cheapest options furthest out.

These are the options with a 90% chance of being in the money.

The problem with trading cheap options that are so far out is that although cheap options have a high probability of success, they have dramatically lower profits overall.

The key is not to look at just the total win rate, but rather to look at total dollars generated.

Case Study:

Set up weekly short strangle entries on TLT (a bond ETF), targeting 40 days until expiration. There was no IV filter in place, no profit taking, and no stop-loss — pure set it and forget it trading. Simply set up the trade and let it go all the way until expiration, win, lose, or draw — no adjustments, no rolling. The only changes made were in the short strikes that were selected.

Setup 1:

On the first run, sold options at the 25 Delta on either side. Theoretically, this trade should be a 50/50 winner. At best, this is set up for a 60% win rate.

Results for Setup 1:

The strategy won 70% of the time, overshooting expected win rate by at least 10 points.

That differential is because of the implied volatility’s overpricing, because the market doesn’t move as far as we would have thought.

The strategy generated a 40% return over the last 10-11 years.

Total profit on a $250,000 portfolio was a little over $100,000.

The annual CAGR was 2.46%

Performed very similar to the S&P, but had dramatically less variance.

During 2008 and 2009, the portfolio did not take as much of a dip as it would have in equities.

The variance in the account and the stability of the strategy was much improved over the S&P.

The max draw-down at any one point in the whole cycle was 27%, again, better than the broad market.

Setup 2:

Same setup as setup 1, with a tweak in the short strikes. Went much further out on the short strikes and sold the 5 Delta calls and the 5 Delta puts on TLT. This strategy should win 90% of the time. Again there was no IV filter, no profit taking, and no stop-loss.

Results for Setup 2:

The strategy won 92% of the time.

The further you go out in selling options, the less often the strategy is going to out-perform what it should do.

At some point you will hit 100% or 99% chance of success if you sell options very far out.

There is a diminishing return factor where if you sell options further out, the win rate starts to slowly creep down.

Since you are selling options so far out to begin with, the strategy only won 2% more than the probabilities suggested.

The draw-down was 13%, which is consistent with a strategy when you win more often.

However, total profit made and total returns dramatically under-performed the market.

There was a 17% return over the entire period.

Annual CAGR was 1.61%.

Total dollars earned on a $250,000 was just $43,000.

Conclusion:

When you sell options that are closer in (15-25 Delta range), you generate more total dollars than you would if you just defaulted to selling options very far out of the money.

Although selling options far out of the money has a really high win-rate, it consistently under-performs the market and generates less total return.

Back-test and optimize your trades, trading within a framework and using it to your advantage.

Free Options Trading Courses:

Options Basics [20 Videos]: Whether you’re a completely new trader or an experienced trader, you’ll still need to master the basics. The goal of this section is to help lay the groundwork for your education with some simple, yet important lessons surrounding options.

Finding & Placing Trades [26 Videos]: Successful options trading is 100% dependent on your ability to find and enter trades that give you an “edge” in the market. This module helps teach you how to scan properly for and select the best strategies to execute smarter option trades each day.

Pricing & Volatility [12 Videos]: This module includes lessons on mastering implied volatility and premium pricing for specific strategies. We’ll also look at IV relativeness and percentiles which help you determine the best strategy to use for each and every possible market setup.

Neutral Options Strategies [7 Videos]: The beauty of options is that you can trade the market within a neutral range either up or down. You’ll learn to love sideways and range bound markets because of the opportunity to build non-directional strategies that profit if the stock goes up, down or nowhere at all.

Bullish Options Strategies [12 Videos]: Naturally everyone wants to make money when the market is heading higher. In this module, we’ll show you how to create specific strategies that profit from up trending markets including low IV strategies like calendars, diagonals, covered calls and direction debit spreads.

Options Expiration & Assignment [11 Videos]: Our goal is to make sure you understand the logistics of how each process works and the parties involved. If you don’t feel confident in the expiration processes or have questions that you just can’t seem to get answered, then this section will help you.

Portfolio Management [16 Videos]: When I say “portfolio management” some people automatically assume you need a Masters from MIT to understand the concept and strategies – that is NOT the case. And in this module, you’ll see why managing your risk trading options is actually quite simple.

Trade Adjustments/Hedges [15 Videos]: In this popular module, we’ll give you concrete examples of how you can hedge different options strategies to both reduce potential losses and give yourself an opportunity to profit if things turn around. Plus, we’ll help you create an alert system to save time and make it more automatic.

Professional Trading [14 Videos]: Honestly, this module isn’t just for professional traders; it’s for anyone who wants to have eventually options replace some (or all) of their monthly income. Because the reality is that mindset is everything if you truly want to earn a living trading options.

Option Trader Q&A w/ Roy

Trader Q&A is our favorite segment of the show because we get to hear from one of our community members and help answer their questions live on the air. Today’s question comes from Roy, who asks:

Have you ever look at selling half of the trades at 50% and then let the rest of the trades go to expiration rather than just selling everything at 50% or picking an arbitrary number like 75%?

Remember, if you’d like to get your question answered here on the podcast or LIVE on Facebook & Periscope, head over to OptionAlpha.com/ASK and click the big red record button in the middle of the screen and leave me a private voicemail. There’s no software to download or install and it’s incredibly easy.

Earnings Trading Guide [33 Pages]: The ultimate guide to earnings trades including the top things to look for when playing these one-day volatility events, expected move calculations, best strategies to use, adjustments, etc.

Guide to Trade Size & Allocation [8 Pages]: Helping you figure out exactly how to calculate new position size as well as how much you should be allocating to your each position based on your overall portfolio balance.

When to Exit/Manage Trades [7 Pages]: Broken down by option strategy we’ll give you concrete guidelines on the best exit points and prices for each trade type to maximize your win rate and profits long-term.

7-Step Trade Entry Checklist [10 Pages]: Our top 7 things you should be double-checking before you enter your next trading. This quick checklist will help keep you out of harms way by making sure you make smarter entries.

Real-Money, LIVE Trading:

EWZ Iron Butterfly (Closing Trade): After nearly pinning the stock at our short strikes, and thanks to the volatility drop, we netted a $600 profit on this iron butterfly trade.

VXX Short Call (Closing Trade): One of the most consistent and profitable options trades we can make is shorting pure volatility with VXX and today we closed this naked short call in VXX after a couple days for a $420 profit.

DIA Iron Condor (Adjusting Trade): This neutral iron condor in DIA is need of a quick adjustment early this week as the market continues to rally. In this video, we’ll discuss why I’m adding an additional put credit spread while also choosing NOT to close out of our current put credit spread due to pricing reasons.

COP Short Put (Closing Trade): These single short puts in COP acted as a great hedge for our other bearish bets in oil this month and helped smooth out our returns after we closed them for a nice big profit.

TSLA Put Debit Spread (Closing Trade): Although many people thought we were crazy for getting bearish in TSLA this pre-earnings put debit spread trade made us $200 today. After the huge run up from $140 to $260 and getting some technical sell signals, we were pretty sure this stock would pull back.

MON Iron Condor (Closing Trade): Following a huge drop in implied volatility we worked hard to close this MON iron condor trade adjusting the order multiple times to fill before the end of the day.

IBB Call Debit Spread (Opening Trade): We’ll show you how I started searching for a new bullish trade and eventually found a low volatility trade in IBB looking for a move higher to hedge our portfolio.

TLT Iron Butterfly (Closing Trade): Following the Brexit vote TLT and bonds traded in a nearly $8 range really quickly – even still the drop in implied volatility helped generate a $330 profit for us.

XBI Call Debit Spread (Closing Trade): Got lucky picking the exact bottom for our entry in this call debit spread for the XBI biotech ETF which ultimately was closed for a profit of $165 today on the rally higher.

EWW Debit Spread (Closing Trade): Using some of the technical analysis signals we discovered in our backtesting research, we were able to make a quick $130 profit on this bearish EWW debit spread trade.

IBM Iron Condor (Earnings Trade): Shortly after the market opened you’ll follow along with me as we watch volatility drop and liquidity come into the market before closing out the position for $250 profit.

SLV Short Straddle (Opening Trade): Using our watch list software we decided to continue to add to our existing SLV short straddle position with a new set of strike prices reflective of the move lower in the ETF recently.

Thank You for Listening!

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